Saturday, December 31, 2011

This is a followup to my previous post, as further need for clarification came about from comments (hat tip Mario). I don't object to the JG itself, as you may already know from past posts, I advocate a government jobs program during a deep cyclical downturn, I just have issues to the permanence being proposed. To me it comes down to either not making JG permanent OR if you want to make it permanent in order to set a stable price level, it should pay at a much lower wage than private sector, especially when going into an economic upturn. Otherwise, why would anyone take a private sector job that can someday be made obsolete by the market when you can always take a safe government-guaranteed JG job that will always be there no matter what. In an upturn, keeping the JG would make the cost to hire more prohibitive for new businesses, and looking at tradeoffs for both employees and would-be employers, it would entail a much higher assured premium for private business to make up for the higher risk of joining or setting up in private industry, when there are government-assured jobs for the taking for all posterity. Usually no one changes jobs unless it's for a higher wage, and no one will want to make the risk for so low a spread over riskless government positions.

I'm not thinking of the big multi-national corporations as those who may suffer here. I'm thinking of your neighbourhood shopkeeper or your local smallscale job creator who only hires 10-20 people at a time. Their profits are not that high, and their tradeoff with starting a business vs just getting a JG may not amount to a lot. Workers will have options when the economy booms again, and this will increase the cost to private businesses, most particularly for those who are small-scale. The JG could very well just crowd out the smallest firms permanently. If their wage costs for hiring 10 people have risen from $400K to $700K a year because of having a JG during a booming economy, that difference could very well be their profit already. And why would anyone continue risking his capital (which could very well be his retirement nest egg) when the JG assures him an assured income/wage for himself, and he also knows his own workers also have the same tradeoffs, and hence, could leave the firm much more easily during the booming economy when his competition for their services is not just other private firms, but government as well?

By keeping the JG in a boom, the wage competition will start at a higher level because of the need to attract workers at the now higher lowest level. This dynamic affects the whole salary structure all the way up to the top. It's just the way it is in a private sector firm, working in a free market.

For example, if there is still a JG program in an upturn, and government is offering $10/hr, then businesses would have to offer maybe $15/hr to attract its most basic workers away from the JG, and therefore, wages for more crucial skills would probably rise from $50/hr to $70/hr, and these could very well be the skills that new developing industries would need to develop their new products and the new markets. And if government increases the minimum JG wage to $15/hr, then perhaps the crucial skills business startups need to hire will now cost $90-100/hr. The JG wage doesn't have to increase much because it has a potentially magnifying effect on all private sector wages during booms. It won't be long before overall wage costs increase 50%, especially if the company employs more of the higher earning people who will now be compensated higher as well. This includes programmers, doctors, lawyers, tradespeople, equipment handlers. It depends on the business, and what the skilled worker brings to it. These people work for firms directly or as contractors, too. And the small businesses work a contractors for other businesses, whose costs also increase when the small business' costs increase. This can be a self-reinforcing cycle during boom times. The skills developed through JG may be good for private business if the workers are going to be available when they are already hiring. But while the demand floor will be a decent life wage during a recession, the higher wage floor will price small businesses out during an upturn. It would not be illogical to think that a permanent JG could actually entrench current big players of the private sector because small up and comers will be priced out of the market for people.

I'm not saying a JG wouldn't advantage workers. They would actually benefit greatly, because the JD gives them more leverage to negotiate during a boom. But what are the costs long-term? Some businesses may get workers, others not without extensive premium. Different situations for different people, but during boom times, there will definitely be a crowding out and/or inflationary effect of government competing for scarce workers during a boom. I wouldn't characterize a JG during a boom a completely free market. If there's a monopoly issuer of currency that competes for scarce resources with private firms that need to generate positive cash flow to survive, it's an uneven paying field.

I applaud efforts to launch community-based JG-sponsored jobs programs that provide livable wages. But you don't want people to keep staying with the same community jobs their whole life. You want them to have opportunities to get back into private industry, and you want private industry to have incentives too to make their risky investments (when we are finally out of this recession). You don't want the JG making the hurdle to profitability much higher for these risky investments. And you don't want these prospective entrepreneurs ending up not being as proactive in developing and investing in their businesses, because they can always go back to getting a JG job if things start to become too difficult with the business. There's just less incentive for risk-taking in this scenario.

There's a difference between having a program with a known end date, where everyone employed there has no choice but to find a job in private industry; and having an open-ended program, that can be used by workers to out-negotiate small businesses the way large businesses used union-busting to out-negotiate the workers. Workers can game the new system to their advantage, negotiate for much higher wages, and then quitting much more easily over the triflest of things, because they can always go back to the JG. If you were the small scale employer, this changes your planning dynamics. At a certain price point, the entrepreneur himself would probably be also thinking he should just take a government job himself.

If we had a JG a hundred years ago, we might still have horse-tending positions, manual candlemaking jobs, and manual weaving positions. We may never have transitioned to the automobile, to the electricity economy, or to mass-produced goods. It would have been up to the government to invent the automobile, innovate the mass-market economy, and to develop the electrical industry. The JG's main aim, if it is instituted, will be to provide jobs to those looking for work, not to come up with new products, or obsoletize those that are currently being offered. I'm not sure progress would have been as great as we have it if everything had been done by an entity that monopolizes the economy like government does. During a boom, a continuing JG could actually lower productivity, innovation and pioneering.

Addendum: I appreciate that MMT acknowledges that price distortions will happen when JG is introduced. But if it stays during a subsequent boom, these distortions will stay, and they will permanently alter the cost structure for private businesses. No need for the JG to chase after private sector wages, because in the first instance, it may already have killed all lowest skilled jobs in the private sector (capitalism makes businesses very tight on cost structure) Perhaps all businesses will just end up outsourcing all lowest skilled jobs to the government. I don't advocate for this to happen, where all businesses could start expecting government to pay for all their minimum wage workers. Wouldn't this be some sort of permanent subsidy to capitalists, a sort of crony assistance to the biggest employers of minimum wage jobs? Ex. Under a JG regime, Walmart could start justifying that they are a JG supporting company that creates a lot of jobs for the JG, so the government better start paying their line workers. I'm sure MMT doesn't intend for this to happen, but capitalism has a way of going around these new distortions, maybe for the worse.

PPS. Re: 100% employment, I agree it's a noble goal. But isn’t it a better goal to just get enough people employed to jumpstart aggregate demand and get the economy working again? Going for 100% at all times puts the economy at risk of becoming dependent on the JG for good. Otherwise, it stops being a countercyclical program, and becomes another alternative economy unto itself, since ensuring everybody has a JG job offer ensures that nobody takes a private sector job unless it’s for a premium above the JG wage. This prices out many small businesses for labour, and probably most startups. And it completely shields workers from making the difficult decisions of making the necessary adjustments and learning new skills, so that they can rejoin the regular economy, wherever its growth is going to be.

Thursday, December 29, 2011

I had been meaning to post on this since I read Cullen Roche's post. While I subscribe to most points of MMT, this is also my point of minor disagreement with MMT. I've never really focused much on the Job Guarantee (JG) in this blog, and I prefer to call it Employer of Last Resort (ELR) program instead. ELR sounds more like a countercyclical program, which gets activated to take the place of lost private sector demand during large economic downturns. JG sounds like a more permanent program, one that guarantees that anyone who wants a job, and who is unwilling and unable to find one in the private sector, is guaranteed to get one in government, anytime anywhere. In other words, while i subscribe to the notion that the government should step in to make up for the loss of private sector 'animal spirits' during a downturn (that borders on depression), I believe this program should be a program that is market-oriented, rather than a fixed-in-place government policy instrument.

Why do I believe the ELR shouldn't be fixed and permanent? My main concern is that a permanently-fixed JG program that pays the industry-standard minimum wage could ultimately replace market resilience, and impede its ability to adapt. An important starting point is to make distinctions between structural and cyclical downturns. A structural downturn is when the private sector is laying off people because they are losing market share in their current realms of activity, and should therefore retool and restructure themselves, in order to better adapt and compete in a changing market. When private companies are retooling, and need to hire the skills they will need to support their new initiatives, they should not be competing with the government as buyers of labour. A permanent government program will add more market frictions to attracting and allocating labour where they are most needed in the private sector.

Meanwhile, the people who lost their private sector jobs should by default be looking at the market to see who is now hiring, who is growing, and then determine what is needed to be learnt to join these growing and hiring firms. They cannot just have a default attitude that says 'Hey, why do i need to learn to program a computer, or transition into the healthcare industry, or be a better salesman, or learn a new trade, when I can get a job in government helping teach kids or clean parks and be at it until the day I retire". A permanent job guarantee disincentives people from learning that new skill that private industry may be transitioning into, particularly if the skill requires effort, or has some risk that the jobseeker may fail at it. Venture and possible failure are essential components of capitalism, and those whole fail at a certain venture need to go and venture elsewhere again. A default program that catches everyone who fails that the first venture will likely make some people too comfortable, and decide that any further risk is probably pointless and unnecessary. A JG program that is expected to disappear, however, once private sector starts hiring in bulk again will make some of those who may otherwise be content with the JG to start planning ahead, even while the government program is still there.

A permanent JG makes it more complicated and expensive for private industry to attract people, because having shifted the risk-return tradeoffs of learning a new trade or joining an new as-yet untested industry, JG could make people less interested in helping new companies succeed, or in helping a new industry to mature. If things start to become too difficult, it may be easier to day "It's okay, we can always just close shop all join the government". The tradeoffs would also shift for the would be small-scale capitalist. "Why would I risk more of my own capital to grow this company, when if a bigger competitor comes in, I can just sell off all my inventory, then I and all my workers can just join the government." This default thinking does not apply to everyone of course, but since this applies to some, it shifts the tradeoff curve for everybody else. Private sector venture seems so much the riskier when it's not the only game in town.

So the question we should be tackling is, how do we recognize when a downturn is cyclical vs structural. How do we recognize when private sector is ready to take off on its own, and thus, any existing JG programs should therefore start winding down. (My guess is that the JG program will have some lag, in that it could be taking in the most applicants just when the first embers of private initiative may already be starting to flicker). And we need to answer how much government participation is needed in turning around the lack of demand. My guess is that it will come down not just at looking at how many people are applying for the JG. You would need to look at how much deleveraging is still happening in the private sector (If people are still heavily in debt, with most income going to service it, they aren't likely to spend or invest on their own sometime soon). You would need to look at why the previous jobs disappeared (Did they disappear suddenly due to a fall in aggregate demand, or did they disappear because this industry is no longer competitive, or providing what buyers want). You would need to see what is in the minds of both the households and industry.

This is something is have not yet seen in discussions about the JG program. While i agree that in the current environment, such a program is what is needed, i doubt that it would always be, and I don't know if everyone who advocates it now would be as open to dismantling it when it's no longer necessary. After all, government is supposed to be an employer of LAST RESORT only.

Sunday, December 18, 2011

The European crisis is escalating, and it seems credit default swaps will once again become a transmission agent of crisis to many parts of the financial system. It's time once again to revisit an old post from 2008, now updated with the latest understanding of how this CDS crisis may play out this time around among the banks. Links courtesy of Bloomberg and Zero Hedge.

The 3 Laws of Risk

1. For every potential return created, we create an opposite potential risk. If banks wish to earn good income in this volatile environment, they need to be willing to take on risk. Why not sell CDS protection to the more risk-averse parties? Or at least, to those who think they need to rein in some risk.

3. In a system where risk has been shared and dispersed among interconnected institutions, any random adverse change in risk in any locality will adversely change the risk in other localities of the system.They are all inter-connected. And all it takes is one party in the chain to not make good on its promise to pay, and many hedges become non-existent. Thus, any additional risk positions entered into by a party, on the expectation that that position had been hedged (with the defaulting counterparty), transforms into pure additional risk for that party. Hence, this party is potentially the next link in the chain to break, and to transfer the additional risk on to its own counterparties, who may have also entered into even more risk positions of their own, with the understanding that they too had been hedged.

These three laws then lead us into extrapolating five major implications of risk on a financial system.

5 implications of risk on a financial system

1. Any firm that tries to hedge its risk by entering into a swap with another party only succeeds in transferring the original risk to another party. Any firm that expects all of its hedges to hold in a large systemic crisis could end up with all obligations corresponding to that now worthless hedge, plus any additional obligations where it agreed to be the counterparty to another party trying to hedge its own risk.

2. Any firm that tries to take on incremental risk, any of which is greater than its capacity to bear, on the assumption that the additional risk will be hedged, could end up with excess obligations corresponding to that excess risk, once its hedging counterparty to that risk defaults. Any obligations it is unable to meet transfers risk to its counterparties, who now have more risk, and much less solid position, than they previously thought.

3. Each party in the chain that offers to be a counterparty creates additional counterparty risk that was not there before. Hence the more firms involved in a chain of counterparty swaps and derivatives transactions, the greater the resulting risk created in the system, since each counterparty could be the weak link that starts to unravel the whole chain.

4. The more interconnected a system, and the more of these types of transactions it has, the greater the likelihood of a systemic meltdown.

5. There is no such thing as a benign or risk-free environment. You can never create an environment where systemic risk has been controlled or made benign by hedging. It only means risk has been put at rest. But the more risk is put at rest, the greater its potential blowup energy, especially if it masks the excess risks that individual parties took that they, individually, could not meet themselves. You may have only succeeded in causing it to implode more fiercely, once the bubble chain starts to unravel.

Saturday, December 10, 2011

1. A bank taking its stock of deposits from net savers and using it fund its lending to others, who are net borrowers.

2. A shadow bank taking collateral posted by its own clients and using that same collateral in its own borrowing from other lenders

If you were zero hedge, you would say they are both examples of fractional reserve lending. At its surface, you would be correct (though I would clarify that the second scenario is more like a mirror image of the first, or more specifically, fractional reserve borrowing).

Shadow banks are back in the forefront due to the escalating Euro crisis, as we see panicked 'shadow bank' lenders increasing their collateral requirements from their borrowers who used PIIGS bonds as collateral, as the value of PIIGS bonds falls. This use of collateral to raise funding in the repo market is called hypothecation. From Reuters:

[h]ypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is “hypothetically” controlled by the creditor, who has a right to seize possession if the borrower defaults.

…..Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations much to the chagrin of hedge funds.

So let's see: a Prime Broker taking posted collateral, then using the same collateral as an instrument for hypothecation with a net haircut, then repeating the process again, and again... Ring a bell? If you said "fractional reserve lending" - ding ding ding. In essence what re-hypothecation, and subsequent levels thereof, especially once in the shadow banking realm, allows Prime Brokers is to become de facto banks only completely unregulated and using synthetic assets as collateral.

I half agree with zero hedge, in that the first scenario above seems like fractional banking, but it's more than fractional, since banks can and do lend funds even though they don't have the deposits to 'fund' the loans yet. Banks don't lend their deposits, it's loans that create deposits - or net new money. Most loans are purely 'electronic debit and credit' debt transactions made by commercial banks, and balance out as an increase in loans (assets) of the financial system automatically increases its liabilities (deposits). Most don't even have to result in actual newly-printed currency circulating the system if the payments and transfers remain electronic.

But unlike shadow banks raising funds via rehypothecation, commercial bank lending has less danger of turning into a bank run because of the lender of last resort function of the central bank. For as long as banks have adequate capital on their books, the system can be considered sound most of the time. When and if a loan goes sour, it is this equity capital that gets depleted first, and only once all capital has been written off, does its deposit base get into some kind of danger (because the bank might close and depositors will be unable to access their deposit). But a lender of last resort always makes sure that the bank will always have the reserves it needs to pay out its obligations to its depositors.

This kind of safety net comes with a cost though - regulation. Thus far, so-called shadow banks have been free of this regulation simply because they don't deal in retail deposits. Shadow banks will argue that they don't need the safety net of a lender of last resort because their retail clients are not looking for the safety (and the lower yields that go with it) of a commercial bank, otherwise they would have made their dealings with a commercial bank.

But with the repeated financial crises magnified globally by these inter-connected and often too big to fail shadow banks, is it still fair to say they don't need a government safety net? How many more bailouts before we face up to reality?

Saturday, December 3, 2011

This post developed from thoughts from comments here. I think China's ace, which could also be considered its curse, is that it has a glut of people it has to provide employment for, or its society may break down. Hence its policies. I think US's ace, which could also be considered its curse, is that it has a glut of capital it has to provide a return for, or its society may break down. Hence its policies.

Capital tends to congregate in the US because of its perceived safe haven. China population is stuck in China because of the constraints of its nation-state borders. We know why they are stuck, but why does all the world capital necessarily have to congregate in the US? Capital is supposed to be free to go almost anywhere in the world nowadays.

This is something that the proponents of market liberalization had not counted on. Capital mobility was promoted as one of the hallmarks of globalization because its natural inclination was supposed to be to go where the returns are, and hence, it was supposed to go to all corners of the world in search of profit, until all the world's frontiers were finally ushered into the same first world standard of living.

It did not happen that way. In its stead, each unit of capital tended to go lemming-like to anywhere in the world the rest of capital tended to go. Where all other capital-holders were going was where returns were being harvested. And because investment return was self-reinforcing, more capital going to one area tended to increase the asset values of its targets there. Hence, it would induce others to pile on and further magnify the positive returns of those who were coming into that area.

It all goes well until people start to believe pie in the sky visions of ever increasing returns. Then the first few capitalists start getting out, stopping the upward trajectory, and thus encourages further others to also cash out. This then now leads to a downward cascade of asset values, leaving those who are slower to move to panic, and finally to leave the area, sometimes, worse off than before the capital ever came.

We see this happening again and again, everywhere. When the barriers to capital mobility first came down, capital did go to the farthest frontiers of the earth, in search for its pot of gold. But once this reflexivity process has driven a local area into manic booms and panicked busts, capital once again leaves that area, and because capital mobility goes both ways, it now brings back with it previously indigenous capital and takes it along for the next wild ride. Example, when barriers to Eastern Europe and to China investment first fell, first world capital came to Eastern Europe/China. Then when capital jacks up the rate of return to the zenith there, capital will once again leave, taking along some home-grown capital, which should have stayed there and built a more sustainable growth, because local capitalists now realize that the piling up of foreign capital to domestic assets has now led to asset values ripe for a crash. Where they want to be is in a safe haven.

Because of the great losses that a crash unleashes on the local populace, especially those who who were the last ones into the headiest assets that crashed, it would likely be years before local capital will once again brave the market again. The aftershocks of the locust-like rampage of capital has probably left an economy over-invested in sectors that now stand devoid of demand, and under prepared in others where a flicker of demand can lead back to a more sustained growth across all sectors.

The irony of it all is that with the liberalization of capital also came the dismantling of laws and institutions of government that would have enabled it to be the investor of last resort in the face of such manic capital merry-go-round. Not only did liberalized markets leave the gates open for some capitalists who turned out to be mere short-term speculators (barbarians), they also threw away the tools that they would need to rebuild once the barbarians have come and gone. All that's left is finger-pointing as to who's at fault. Such is the behaviour of people who have no other choice but to sit, close their eyes, and wait for either a miracle or for it all to end. Moral of story is, when you liberalize the market, you also need to strengthen government to act as cleanup crew in case things get out of hand.

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"Conventional approaches, unconventional conclusions" on the global finance and economic issues of the day. Rogue Econ has been a banker and financial consultant in several countries. Welcome to my blog.